In his new book MISUNDERSTANDING FINANCIAL CRISES: Why We Don’t See Them Coming, Gary Gorton explores how the economic “Quiet Period” from 1934-2007 left economists fundamentally unprepared for the financial collapse that was to come.

Gorton offers a back-to-basics overview of financial crises, showing they are not rare events caused by a perfect storm of unconnected factors. Rather, he argues that financial crises are due to an inherent feature of market economies: the vulnerability of short-term bank debt. He explains that the most recent crisis revealed this vulnerability, but this time, unlike in the Great Depression, the debt was in the wholesale banking market. Regulations that prevented crises since 1934 did not keep up with the innovation in the financial sector, due largely to misunderstandings on behalf of economists.

A clear account of the intricacies of the financial market, MISUNDERSTANDING FINANCIAL CRISES provides an authoritative challenge to prominent schools of thought within economics in order to offer a better way for economists to think about markets and regulation necessary to address the threat of future financial disasters.

Misunderstanding Financial Crisis
Why We Don’t See Them Coming
By Gary B. Gorton

“The book offers essential insights into the mysteries of the recent financial crisis. Gorton has the rare depth of understanding to explain the elements and similarities of a wide array of historical crises. Fascinating reading.”
—Robert J. Shiller, Arthur M. Okun Professor of Economics, Yale University, author of Irrational Exuberance and Finance and the Good Society

“Professor Gorton has produced an excellent, readable and incisive account of the recent financial crisis in historical perspective. We, as economists, have an obligation to understand our own profession’s failings in the policy framework leading up to the financial crisis. Gorton shows us that blind faith in mathematical models of idealized economies can lead to blind spots in regulators’ view of economic reality. This phenomenon had disastrous consequences during the 2008-2009 financial crisis, as intricately documented in this book. The book presents important lessons for how financial regulatory reform should be designed and implemented in the future. In addition, it provides a cautionary tale for economists to rethink their approach to policy advice more generally.”
—Justin Yifu Lin, Chief Economist and Sr. Vice President, World Bank

“Financial Crises have been a feature global finance for centuries, but economists and other analysts still struggle with the subject. If anything, since the events of 2007-2009 and the more recent crisis in Europe our fears have only grown larger. In this timely new book Gary Gorton reviews history, theory and evidence concerning financial crises, their causes and possible research and policy responses. It is at the same time very thorough and very interesting, and will no doubt appeal to academics and practitioners.”
—Arminio Fraga Neto, former President, Central Bank of Brazil, Founder, Gavea Investimentos

Praise for Slapped By the Invisible Hand:

“To understand the actual moment and mechanism of crisis, the definitive take is Yale economist Gary Gorton’s, in the delightfully titled Slapped by the Invisible Hand. Gorton’s is a challenging book for a non-finance type, but there is no better technical explanation of the panic.”
-Slate.com

“Slapped by the Invisible Hand tells us that there were bank panics—systemic crises—in 1873, 1884, 1890, 1893, 1896, 1907, and 1914. On the other hand, there were no systemic crises from 1934 to 2007. The problem, as Gorton makes clear, is that the Quiet Period reflected a combination of deposit insurance and strong regulation-undermined by the rise of shadow banking. So we have a choice: restore effective regulation or go back to the bad old days.”
-Paul Krugman, New York Times “Conscience of a Liberal”

“Slapped by the Invisible Hand is essential to understanding the deep weakness in the banking sector that led to the financial crisis. Like consumer banks before the Great Depression, the ‘shadow banking market’ is vulnerable to runs and panics and hysteria, and we are all, in turn, vulnerable to it. By looking beyond this financial crisis to the systemic flaws that make us vulnerable to all sorts of crises, Gary Gorton has created a necessary guidebook for what’s happened, and what needs to be done.”
-Ezra Klein, Washington Post

About the Author:
Gary B. Gorton is the Frederick Frank Class of 1954 Professor of Finance at the Yale School of Management. He is the author of Slapped by the Invisible Hand: The Panic of 2007.

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

6 Responses to “Misunderstanding Financial Crisis: Why We Don’t See Them Coming”

I always just looked at it if it doesn’t work in the micro perspective looking at it exclusive of inflation, meaning looking at 1 person, it isn’t going to work in a macro perspective.

So, my outlook is we work about twice as many years as we are retired. So, say you want 50% of your income in retirement. To me that means somehow 25% of your earns has to somehow make it to a retirement fund. If that idea doesn’t make sense on an individual level it certainly isn’t going to make sense on a macro level.

When we talk about getting a return on our investment it ultimately means other people working to give us that return.

So, the whole belief system really only works for a few and for it to work others are putting in way more then they are getting.

“Compounding” really doesn’t make something out of nothing, it just shifts things around, or it falls apart.

I don’t know. . . this sounds like it going to really complicated to understand when may it isn’t. First, as time goes by,turns out there were lots of people who saw it coming and the closer they were to mortgages being written the easier it was to see. But not the rating agencies? WTF! The dust is settling on this and more an more it comes back to S&P and Moodys . . if they had understood and called it the virus would not have spread. And no one goes to jail for stealing a decade of growth from the American economy, yup that’s where we live. There is no reason to think BO will change this. There is proof that Mitt will encourage it.

In looking at how things collapse I have found a similar process at work. This process would apply to societies in economies, financial markets, riots, attacks within wars and wars. It also applies to forests (fires), sandpiles (collapses) and earthquakes. The process is a positive feedback loop with typically a power-law distribution. Positive feedback loop systems will always blow up unless it also experiences negative feedback from time to time.

As a forest grows it builds up dead trees and bushes. It also fills in all gaps. It experiences negative feedback from time to time through small fires. If firefighters put out all fires, then the forest will gradually position itself for a massive unstoppable fire. Yellowstone National Park took about 100 hundreds before it was wiped out in a massive fire due to firefighters putting out all fires.

Economies work the same way as forests. Over time bad behavior (bad ideas, bad decisions and corruption) builds up. Recessions come along at a regular basis to burn out the bad behavior. But what if the recessions are always cut short? This is just like bringing in firefighters. Cutting short the recessions allows the bad behavior to build up so much that the economy must experience a massive meltdown to fix the problems. People don’t notice this because it happens very slowly over many years.

Sadly, the problems of bad behavior are not restricted to the economy. They spread throughout all aspects of society. So if you thought the financial crisis was about the economy and finance, then you would be wrong. It’s about everything. And the only solution that will fix the problems is a big crash and lots of pain. If you don’t like that solution then welcome to Japan.

It’s about to get worse. Bad ideas and bad decisions also extend into national security. There is a big article in The Atlantic magazine called General Failure. This is about how the military has a process in place that tends to force out the best and leave the mediocre in terms of leaders. US military leadership is in trouble.

Finally, it’s about to get even worse than poor military leadership. The historical signs of war are present. Many threats of nuclear war are coming out of Russia and China. China is right now in the process of taking the Senkaku Islands from Japan. This is otherwise known as an act of war. The US has disarmed so much that it can only retaliate one time. Time to start getting worried.

Looks like a replay of the Great Depression plus World War II. Perhaps not exactly but in a general sort of way.

If the forest fires are the result of individuals repeatedly & intentionally throwing gasoline into dry areas and igniting them, I’d expect those individuals be stopped without having to wait for them to get burnt by the “natural” forest fire they started.

That’s the problem with your metaphor, it oversimplifies the reality, assumes this recession had natural forces of supply/demand as a cause.

It was anything but natural, in this metaphorical forest fire, the park rangers were paid by the arsonists to look the other way, now the arsonists are getting off Scott-free and pawning the costs of their actions onto everyone else….all the while readying the matches & accelerants for the next fire.

It’s time we stop diluting blame onto the victims of that “forest fire” and start looking at both the arsonists and rangers in their complicit partnership to ignite forest fires.

Wall st and it’s bribed influence over D.C. is what did this, not any natural forces of supply/demand and until something is done to stop the legalization of bribery, we can expect more of the same from countless sectors, not just Wall St.

Matt I like your analogy .. FM is just pointing out finger point’g is a __ … its the OpSys of thousands of years to overcome .. let the fire begin so that we can restart anew and create that so needed rooted demand .. best wishes children in that bunker – you are so captured … “dazed and confused for so long its not true”

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